The “(g)(6) Rules” – Restrictions on a Taxpayer’s Access to Funds During a 1031 Exchange
Attention to detail is essential for any investor completing a 1031 exchange to ensure adherence with all applicable rules and regulations. Fortunately, most taxpayers find that with the guidance of their independent tax or legal advisor and with assistance from their Qualified Intermediary (“QI”), an exchange can be taken one step at a time with the process broken down in a manageable way. However, it is still advisable for investors to learn as much about the exchange requirements as they can ahead of the sale of their relinquished property. Perhaps the most important concept for a taxpayer to understand before their exchange commences is the restriction on access to their funds during the 180-day exchange period. Knowing when and how their funds can be accessed for purposes other than the acquisition of replacement property in the exchange can be pivotal information; this knowledge may inform the approach an investor takes in identifying property or in determining how the exchange can best suit their needs. To understand what this restriction on access to funds entails, and why it exists, it is important to first understand the concept of “constructive receipt.”
What is Constructive Receipt?
A taxpayer “receives” sales proceeds (or other consideration) for income tax purposes when their real estate sale closes, and they receive the funds directly. They are also considered to have received funds from a sale when they have the right to receive the funds, even if they are not in actual possession of them – this is when constructive receipt occurs. If, for example, a taxpayer’s agent or some other third party takes possession of sales proceeds at closing instead of the taxpayer, the taxpayer will still be considered in constructive receipt of those funds because they have a right to them, as the property has been transferred to the buyer and contractually the consideration is due to the seller of the property at that point.
The QI’s Role in Preventing Constructive Receipt
There are several essential guidelines for completing a successful exchange outlined in Chapter 26 of the Code of Federal Regulations, Sec. 1.1031(k)-1 (the “Treasury Regulations”). One of the most important requirements is that an exchanging taxpayer must avoid actual and constructive receipt of their funds when selling their relinquished property in an exchange. In other words, to benefit from a 1031 exchange, a taxpayer cannot have any right to access their proceeds at the sale of their relinquished property.
The Treasury Regulations establish rules for creating “safe harbor” exchanges, including a safe harbor option to use a QI to hold proceeds. A safe harbor exchange is one which, when set up in compliance with the Treasury Regulations, will protect a taxpayer from having constructive receipt of their proceeds. The regulations require that the taxpayer and the QI must enter into an exchange agreement that limits the taxpayer’s access to their proceeds during the life of the exchange, as described in more detail below. These limitations are outlined in Sec. 1.1031(k)-1(g)(6) and often referred to as the “(g)(6) rules”. At the sale of the relinquished property, in conjunction with the exchange agreement, the Exchangor assigns its rights as seller to the QI, so that the QI has a right to receive and to hold the exchange proceeds during the exchange period. During that time the QI directly funds the taxpayer’s acquisition of replacement property using the proceeds, while the taxpayer is protected from constructive receipt.
The (g)(6) Rules
The (g)(6) rules, as referenced above, specify exactly what events trigger a QI’s ability to release funds to a taxpayer without causing constructive receipt (which could risk the taxpayer’s exchange or the integrity of the safe harbor offered by the QI). As previously mentioned, these timing requirements must be included in the exchange agreement that is signed between the QI and taxpayer at the commencement of the exchange. A taxpayer, once the exchange has begun, may not receive funds from the exchange until the earliest to occur of the below events:
i. The 180-day exchange period ends;
ii. The 45-day identification period ends, if no replacement property has been identified by the taxpayer by day 45; or
iii. The taxpayer has received all replacement properties identified in their exchange prior to the 180th day.
(g)(6) Scenario Examples
The (g)(6) rules can be illustrated with the below examples:
Example 1 – A taxpayer identifies three replacement properties before their 45th day. By Day 85 of their exchange, they’ve acquired all three replacement properties, and have some funds remaining in their exchange account. Because all identified properties have been acquired, the QI is able to release the remaining funds to the taxpayer as early as day 85 (the date all replacement properties have been acquired).
Example 2 – A taxpayer identifies three replacement properties before their 45th day. By Day 85, the taxpayer has acquired two of the three identified properties, and wants their excess funds returned to them. The QI cannot release any remaining proceeds to the taxpayer yet, because one property remains identified but unacquired. Any excess proceeds can be released to the taxpayer when the third property is acquired, or after day 180 (when the exchange period ends), whichever occurs first.
Example 3 – A taxpayer identifies no property and their 45th day passes. Because no property is identified, the exchange is considered over and the QI releases funds to the taxpayer on day 46.
Example 4 – A taxpayer identifies two properties prior to their 45th day. They never acquire either of them. QI must hold the proceeds until after the exchange period ends on day 180.
It is important for taxpayers to be aware that depending on the number of properties they identify, their manner of identifying those properties, and what they’re able to actually acquire, they may have some funds tied up in the exchange account that they contractually (and pursuant to the Treasury Regulations) cannot access until 180 days (or approximately six months) after their relinquished property closes.
Commonly Asked Questions - Answered
Q/1 What if I have funds remaining in my exchange account after I’ve acquired all the property I plan to acquire – but one property is still identified that I do not plan to acquire? Can I have my funds back before day 180?
A/1 A QI is unable to release funds to an exchangor when property remains identified, as they would be in violation of the terms of the exchange agreement required by the (g)(6) rules. However, there are ways a taxpayer can go about avoiding this predicament. One is to be mindful of the identification deadline. If, prior to midnight on the 45th day of the exchange, the taxpayer knows that it will not be acquiring one or more of the properties they already identified, it may make sense to revoke the identification of any such properties. The revocation must be made in the same manner the identification was – i.e., in a signed writing, delivered to the QI, prior to midnight on day 45 of the exchange. A taxpayer can also explicitly communicate their intention to acquire a limited number of the properties they’re identifying in total on their identification form. The manner in which this should be done should be discussed with the taxpayer’s tax or legal advisor and QI. This may allow the QI to release excess funds as soon as the intended number of properties to be acquired have been acquired, if prior to day 180.
Q/2 It is day 30 of my exchange and I’ve identified and acquired all the property I intend to during the exchange. Can I receive excess funds held by the QI before the identification period is over?
A/2 Since a taxpayer has the ability to identify additional property within what remains of the 45-day identification period in this scenario, it is not possible to definitively state that a taxpayer has acquired all identified properties to which they are entitled – they could still technically identify additional properties before the 45-day period has expired. Thus, it is only possible for funds to be released after the 45th day, when the taxpayer no longer has the ability to identify additional property.
Q/3 When can the QI make an exception and release funds prior to the times outlined in the (g)(6) rules?
A/3 In many cases it could put a taxpayer in constructive receipt and potentially destroy their exchange should excess funds be released early. To do so could also compromise the QI’s safe harbor because the safe harbor could be deemed “illusory,” thereby compromising the exchanges of all taxpayers the QI has exchange agreements with. In very rare cases, a taxpayer may receive funds early upon the occurrence of a material and substantial contingency that (1) occurs after the expiration of the identification period, (2) relates to the exchange, (3) is provided for in writing, and is (4) beyond the control of the taxpayer and of any disqualified person (other than the seller). The examples of such occurrences provided by the IRS are: destruction, seizure, requisition or condemnation of the replacement property by the government or some other party not involved in the transaction. The IRS has also established that a material and substantial contingency does not include a circumstance where the taxpayer has the ability to walk away from an economically unfeasible deal, because such circumstances are not entirely out of the control of the taxpayer. However, apart from these exceedingly rare exigent circumstances, there are unfortunately no exceptions to the (g)(6) rules regarding restrictions on a taxpayer’s access to funds.
Q/4 What do I do if I know that prior to the end of the 180-day exchange period, I’ll need some of my proceeds for another purpose?
A/4 If a taxpayer knows that they will require funds for a purpose unrelated to their exchange, prior to day 180 after the sale of their relinquished property, they should plan to receive those funds directly from the closing of the relinquished property, with the balance of funds to be sent to the QI. It is important for the taxpayer to go over the figures of the sale with their tax advisor to ensure that receiving some proceeds directly from the closing (as taxable boot) would not negate the benefit of exchanging using the remainder of proceeds. However, this approach affords the taxpayer the most flexibility if, planning ahead, they are aware that they will need the funds during the exchange period. If this is not done, and the QI receives all funds, the QI would not be able to release them in any amount to the Exchangor unless one of the events outlined in the (g)(6) rules occur.
It is essential for a taxpayer to go over the (g)(6) rules carefully, prior to their exchange, so that they have an understanding of when they can receive their funds (if applicable), and of what approach they will take in identifying potential replacement properties. The investor should review their goals and all potential courses of action with their independent tax and legal advisor, and work with their QI to ensure that they are able to work within the bounds of the (g)(6) rules in completing their exchange.
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First American Exchange Company, LLC, a Qualified Intermediary, is not a financial or real estate broker, agent or salesperson, and is precluded from giving financial, real estate, tax or legal advice. Consult with your financial, real estate, tax or legal advisor about your specific circumstances. First American Exchange Company, LLC makes no express or implied warranty respecting the information presented and assumes no responsibility for errors or omissions. First American, the eagle logo, and First American Exchange Company are registered trademarks or trademarks of First American Financial Corporation and/or its affiliates.